By Jon Sindreu

America's vast military-industrial complex has many critics. For Europe, it is now something to aspire to.

This week, Germany asked the European Union to invoke an emergency clause exempting defense investment from spending rules, as part of the bloc's five-year rearmament plan. Global defense expenditure experienced the highest year-over-year rise since at least the end of the Cold War in 2024, Stockholm International Peace Research Institute data showed this week, with Europe as the main contributor. Analysts estimate NATO members could add EUR700 billion ($798 billion) to EUR2 trillion in extra military spending by 2030.

Of course, much of the windfall will flow to prime U.S. contractors such as Lockheed Martin, Northrop Grumman and General Dynamics. But Brussels wants at least 50% of European military procurement to go to domestic firms. Achieving that requires major industrial reform -- something investors are eager to capitalize on as the U.S. growth story loses its shine.

Because European countries slashed military budgets a lot more than the U.S. after the Cold War, their domestic defense suppliers became niche, low-volume producers with high unit costs. Airbus's military arm was the highest-grossing one in 2024 with EUR12 billion in revenue -- barring BAE Systems, which gets half its sales from the U.S. By contrast, Lockheed grossed $71 billion.

This has created a negative feedback loop, with NATO members increasingly channeling off-the-shelf purchases toward American contractors, which remain capable of large-scale production. Following Russia's invasion of Ukraine, only 22% of the EU's procurement boost remained in Europe, according to the European Commission.

The clear, first step to fix this is producing more of what Europe already makes: ammunition. After the EU failed to deliver one million artillery shells to Ukraine by March 2023 -- it took until November -- officials in the bloc allocated EUR500 million to scale output. A quarter went to Rheinmetall, which targets output of 1.1 million 155mm shells a year by 2027, and tripling annual revenue to EUR30 billion by 2030.

Rheinmetall wants to evolve into an American-style, all-purpose contractor. It recently acquired U.S. vehicle maker Loc Performance, ammo recovery firm Stascheit, and software developer blackned, and bid for Thyssenkrupp's warship arm, which was rejected in favor of a spinoff.

However, investor enthusiasm has pushed its forward price-earnings ratio to 43, from 17 six months ago. Such extreme valuations argue for diversification, but it is hard to spot other clear winners in an industrial base wastefully fragmented across national lines.

Germany is a leading manufacturer of tanks but, where the U.S. fields the Abrams main battle tank, the Bradley infantry vehicle and the Stryker personnel carrier, Europe has several competing models for each tank class. Ditto for frigates, submarines and planes.

In jet fighters, the Eurofighter Typhoon, backed by Germany, Italy, Spain and the U.K., competes with France's Rafale and Sweden's Gripen. But the most popular choice among European NATO members is the F-35, which boasts stealth capabilities and triple the production rate. This locks countries into U.S. systems for two decades. Next-generation fighter development is split too, between a Dassault-Airbus program and a BAE Systems- Leonardo-Mitsubishi team.

Ideally, these firms would merge into two giants, each bidding for a unified contract, with only one aircraft ultimately developed, just as Boeing and Lockheed did with the U.S. Air Force's F-47 project.

In practice, top-tier mergers remain unlikely. National governments retain stakes in most defense firms and are reluctant to cede control.

A more realistic model is missile maker MBDA. Jointly owned by Airbus, BAE and Leonardo, it functions as one company while retaining national subsidiaries. This allowed simplification: The Aster missile family -- Europe's closest equivalent to the U.S. PAC-3 MSE, used in the Patriot systems that have proven vital in Ukraine -- has replaced legacy systems such as the Crotale, Masurca, Spada, Aspide and Sea Dart. MBDA plans to double production this year from 2023.

This model could extend to other sectors. Rheinmetall is developing the Panther KF51 tank, aimed at replacing the Leopard 2, and has now joined forces with Leonardo to build a variant for Italy. Naval capabilities could be consolidated across BAE, France's Naval Group, Germany's Thyssenkrupp, Italy's Fincantieri and the Netherlands's Damen.

Investors could spread bets across listed players, hoping to reap the benefits of their networks of specialized subsidiaries.

Still, the MBDA blueprint remains vulnerable to national divergence. MBDA Germany and France, for example, make competing land-attack cruise missiles: The Taurus KEPD 350, now restarting production after a five-year pause, and the SCALP EG. This reflects premerger legacies, but highlights the challenge of scaling with stale, legacy lines. University of Oslo's Fabian Hoffmann estimates combined annual capacity is just 100 units, which is far below Lockheed's 700 JASSM-ERs.

Meanwhile, Europe lacks a high-altitude missile defense like the U.S. THAAD or Israel's Arrow 3, which can take 20 years to build. It also depends on the U.S. for software and satellite intelligence.

"It is best to first fix the procurement system, then have these companies compete with each other and then see which winners are emerging and drive consolidation. It is what happened with Rheinmetall," said Hoffmann.

Indeed, the EU seeks to replicate the Pentagon's power as a centralized buyer. It will make EUR150 billion in loans available for joint defense procurement and has set up a target for 40% of purchases to be collaborative by 2030. That may not be enough.

With many countries still reluctant to spend even under the auspices of Brussels, though, there will still be a lot of capital stepping in to finance smaller defense deals, usually involving assets owned by unlisted companies.

Private-equity firms such as London-based Tikehau Capital and Paris-based Weinberg Capital Partners are now focusing on security-related small and medium companies, and larger players such as CVC Capital Partners are perfectly positioned to do even more.

Then there is venture capital, which should help address some of the "capability gaps" that EU officials have identified, including drones, artificial intelligence and cyberwarfare. The models are the many Silicon Valley upstarts currently vying for Pentagon contracts, such as Anduril Industries, Palantir and Shield AI.

According to a recent report by NATO Innovation Fund, a EUR1 billion vehicle launched by NATO in 2023 to provide early support to strategic military technology, European VC funding in this area was at a record high last year. The success of Ukrainian producers of small drones, sprouted out of necessity, have also pointed the way.

There is another straightforward way to play the trend: The top European investment banks, such as BNP Paribas and Deutsche Bank, are set to receive a fee windfall in the form of advisory services for mergers and restructurings, as well as equity and debt issuance to fund expansions.

The European military-industrial complex won't rival the U.S.'s anytime soon, but there is money to be made as it wakes up from a long slumber.

Write to Jon Sindreu at jon.sindreu@wsj.com

(END) Dow Jones Newswires

May 01, 2025 23:00 ET (03:00 GMT)

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